Special Allocation

A partnership allocates depreciation deductions on a building disproportionately to Partner A under a special allocation in the partnership agreement, while Partner B receives a much smaller share of those deductions. When the building is later sold at a gain that triggers depreciation recapture, how is the recapture income most likely allocated between the two partners?

1. A.Equally between the two partners, since recapture is a sale-year event unrelated to how the original deductions were dividedWrong. Recapture is not divided independently of the prior deductions; it generally follows the same allocation as the depreciation that produced it.
2. B.Entirely to Partner B, since Partner A already received the benefit of the larger depreciation deductions during operationsWrong. This reverses the rule -- the partner who claimed more depreciation recognizes more of the resulting recapture, not less.
3. C.In proportion to each partner's current capital account balance at the time of sale, regardless of how the depreciation deductions were originally allocatedWrong. Capital account balance at sale is not the governing benchmark; the recapture follows the original depreciation allocation.
4. D.Consistent with how the underlying depreciation deductions were allocated, so Partner A, who claimed the larger share of deductions, recognizes the larger share of recapture incomeCorrect. Recapture income tracks the allocation of the depreciation deductions that generated it.

Why: Depreciation recapture income generally follows the same allocation as the depreciation deductions that produced it, so the partner who claimed the larger share of the deductions recognizes the larger share of the recapture.

A real estate limited partnership's agreement purports to allocate 90 percent of a particular year's tax losses to one limited partner who contributed relatively little capital, while giving the other, larger-contributing partners only a small share of that same loss, with no corresponding adjustment to how cash would actually be distributed if the partnership dissolved that year. Is this special allocation automatically respected for tax purposes simply because the partnership agreement provides for it?

1. A.Yes -- partnerships have unrestricted freedom to allocate income and loss however the partnership agreement specifies, and any allocation written into the agreement is automatically respected for tax purposes.Wrong. Allocation flexibility is not unconditional; special allocations must have substantial economic effect to be respected.
2. B.Not automatically -- a special allocation is respected only if it has substantial economic effect, generally requiring that capital accounts be properly maintained and that the allocation actually track who would bear the economic burden or benefit if the partnership liquidated; an allocation lacking that real economic backing can be reallocated by the IRS according to the partners' actual economic interests.Correct. Special allocations require substantial economic effect to be respected for tax purposes.
3. C.No -- special allocations of losses are never permitted under any circumstances; partnerships may only allocate items strictly in proportion to each partner's capital contribution.Wrong. Special allocations are permitted; they are simply subject to the substantial economic effect requirement, not banned outright.
4. D.Yes, but only if the allocation is approved in writing by the partnership's accountant before the tax year begins.Wrong. Accountant sign-off is not what makes a special allocation respected for tax purposes; substantial economic effect is the governing standard.

Why: A special allocation is respected only if it has substantial economic effect, generally requiring that capital accounts be properly maintained and that the allocation actually track who would bear the economic burden or benefit if the partnership liquidated; an allocation lacking that real economic backing can be reallocated by the IRS according to the partners' actual economic interests.